Optional Extras

In July 2001 Marconi watched its share price collapse, putting executive share options under water. So the board decided to put forward a proposal to reprice the options, which looked like moving the goalposts to some investors. Then, one shareholder stood up at the AGM and said, “Isn’t it a myth that share options work to incentivise people? Otherwise, we wouldn’t be in this mess …”

Few corporate collapses have been as spectacular as that of Marconi. The company’s shares fell from a high of £12.50 to a low of 2p. But if the law of rebounds – what goes down must come up – works in Marconi’s case following its £4bn debt-for-equity reconstruction, chief executive Mike Parton will do very nicely, thank you.

Parton is one of 60 senior executives at Marconi, including chairman John Devaney and chief operating officer Michael Donovan, who may benefit from share options. He has been awarded options over 17.5 million shares, which he can exercise if he meets a range of performance criteria, including bringing the company back into the black within five years.

Quite unusually, Marconi’s management get free options potentially worth as much as £1 a share if they meet debt repayment targets over the next two-and-a-half years and push the company’s market cap to £1bn after three years and £1.5bn after five. But they have had to forgo cash bonuses and pay rises for a year. If they achieve their targets, management will end up owning 12% of the reborn company.

The Marconi share option plan, published in March, attracted little hostile comment and came at a time when the future of share options was being pondered by increasingly querulous remuneration committees. Two developments have pushed the issue up the agenda. The first is the proposed change in accounting treatment of share options, which looks likely to come into operation as early as next year. The second is the new bout of muscle-flexing from normally quiescent investment advisory bodies such as the National Association of Pension Funds and the Association of British Insurers.

Both have questioned share option schemes that flout their governance advice.

Most recently, for example, NAPF has been complaining that software company Autonomy has handed share options to non-executive directors – a definite no-no in good governance because it compromises the independence of the non-execs. Autonomy defended itself by saying it had stopped the practice but couldn’t cancel existing options without breaching US listing rules, where it is also quoted.

And earlier this year, the ABI criticised an option scheme at publisher Reed Elsevier, which could net chief executive Crispin Davis £8.3m and FD Mark Armour £4m. The ABI was concerned that the proposed one-off award of shares contravened its best-practice governance guidelines. The new options replaced existing options that had run into difficulties after a sustained bear market in the media sector.

All this comes in a climate when the tabloid press seems to be working itself up for a further bout of ‘fat cat’ headlines. And shareholders are starting to exercise their right to vote at annual general meetings over directors’ remuneration packages. Beyond these trends, there are thoughtful remuneration consultants who are beginning to question the value of share options anyway.

In any event, new research from employee share scheme consultants at law firm Pinsents suggests that as many as 40% (by value) of currently granted share options are under water – the share price is lower than the price at which the options can be exercised – following a sustained bear market. An underwater option retains some incentive value, providing it stays close to the surface, although this fades as it sinks deeper below the quoted share price.

So, could share options cease to be the alluring incentive for directors and senior managers they once where? No, says David Pett, head of share schemes at Pinsents. “The share ownership culture remains strong in the UK and, despite the bear market we are currently experiencing, share incentives are evolving and continue to be firmly rooted in the culture of companies.”

Possibly, says Peter Jauhal, a senior consultant at executive compensation consultancy Inbucon-Meis. “There could be a switch to cash incentives or share grants below board level, where senior executives don’t really have a direct influence over share price. But I think at board level it is going to be difficult to have a cash plan because institutions will probably want the board to hold shares.”

The issue that has precipitated the debate more than any other is the proposed new accounting standard, which will require companies to expense share options in their accounts. The International Accounting Standards Board has now collected comments on the exposure draft on share-based payment it published last year. It is expected to publish the formal standard in November with it coming into force for accounting periods beginning on or after 1 January 2004.

The UK’s Accounting Standards Board agrees with the IASB approach, which is based on three central principles – that share-based payments should be recognised as an expense, that the expense should be recognised over the period in which the services (or goods) are received, and that the expense should be measured by using ‘fair value’.

There seems little doubt that booking share options as an expense will hit bottom lines. But it remains to be seen whether early estimates of a £5bn hit to UK firms’ profits is borne out in practice. But even IASB chairman David Tweedie has acknowledged that technology companies, such as Logica or Xansa, could be hit.

A survey by employee share ownership lobbyists Proshare found that 40% of companies would be unlikely or highly unlikely to continue all-employee option schemes, even though 68% planned to carry on with options for executives.

Companies in the Proshare survey were expecting an average 5% hit in profit from expensing share options. “It’s a shame that everyone else is going to pay the price because of the excesses of a few directors,” says Diane Hay, chief executive of Proshare. But that assumes that expensing share options is only needed as a policing measure for the irresponsible rather than being a prudent accounting principle.

There has been plenty of grumbling from business about the expensing plan, but in the wake of accounting scandals on both sides of the Atlantic, there is grim acceptance that the IASB and ASB will stick to their guns and the new rules will go ahead. One effect of expensing share options will be to make their cost more visible in the annual accounts. And that is likely to mean that shareholders will regard schemes that fail to observe good governance principles with an increasingly jaundiced eye.

Remuneration committees should take a close look at existing and proposed schemes before the new accounting rules come into play.

So just what will shareholders regard as good governance in share option schemes? There are plenty of rules and guidelines to go by as well as a thick undergrowth of legislation. Relevant statutes include company law, tax law and the Financial Services and Markets Act 1998; rules and guidelines include the Listing Rules of the UK Listing Authority, the Combined Code (an appendix to the Listing Rules) and the Association of British Insurers guidance on employee share incentives, the most recent version of which was issued in February 2003.

With such a body of well-established governance guidance, it is surprising that it is not scrupulously followed. It would be wrong to suggest that transgressions are widespread, but they are not rare. For example, the ABI guidelines state that options should not be vested with directors unless they achieve at least median performance, based on whatever measure is chosen. Yet Pinsents’ research turned up two FTSE-100 companies that ignored those guidelines. Similarly, there are other companies that fail to link share options to a clear performance measurement regime.

At the heart of the governance debate are two questions that are difficult to answer. The first is whether the options granted are reasonable in the circumstances. Pensions Investment Research Consultants (PIRC) deals with the reasonable question in its guidelines on share incentive schemes.

It argues that salary and incentives are not excessive providing that, first, the base salary is in line with the company’s sector and, second, that incentive bonuses (including share options) represent no more than 150% of base salary in any one year. It also believes that profit-sharing schemes to enable all employees to benefit from business success are a key element in judging whether the directors’ and senior executives’ incentives are reasonable.

Pinsents’ survey found that the average value of shares over which performance-linked options had been granted to chief executives in FTSE-350 companies amounted to 295% of base salary, excluding bonus. Companies with long-term incentive plans had awarded an average 122% of base salary in options, subject to full performance. The second question is what performance measures are used to determine whether directors and other senior executives should receive their options. Pinsents’ study found that 65% of FTSE-350 companies with executive share option schemes use adjusted earnings per share.

Just 17% total shareholder return (TSR) and 13% other measures of corporate performance, including economic value added (EVA).

Judith Greaves, a partner at Pinsents, says that EPS has the merit of simplicity while TSR, although more sophisticated, is more difficult to measure, especially if TSR is being compared against a basket of other companies. So which measure should a company choose? “There are a lot of factors to consider, including what competitors have done, sometimes what is simplest and what shareholders are expecting,” says Greaves. “For example, a more mature company which doesn’t expect profit levels to be increasing might think it’s doing well if it keeps pace with competitors, so it might choose total shareholder return. But there are no hard and fast rules.”

Jauhal believes that simple measures such as EPS are “not very robust”. He argues that too many targets are “soft”. For example: ‘Increase EPS by 2% more than the retail price index in any three-year period over 10 years.’ This is easily achievable by a wide range of companies, he argues.

“It tends to be possible for some directors to earn options even if their company isn’t performing well.”

The ABI guidelines say that performance conditions should be measured over three or more years. They encourage companies to use longer measurement periods of more than three years and defer vesting in order to motivate executives to achieve sustained improvement in financial performance.

To assuage shareholder criticism of executives receiving large rewards for mediocre performance that exceeds benchmarks, more companies have moved to sliding scales. PIRC argues that maximum vesting should only take place for significant out-performance. If options awards are reaching twice base salary, it wants performance that significantly exceeds brokers’ forecasts or is in the top decile relative to a comparator group of companies.

Barclays plc, for example, has defended options worth up to £9m it has awarded chief executive Matt Barrett on the grounds that they are linked to a sliding scale and that Barrett will only reap full benefit if the bank is ranked first among 12 rivals over three years. If it comes second, Barrett’s options fall from 7.8 million shares to 5.9 million. If it falls below sixth place – the median point – he gets nothing. Even so, the scheme raised eyebrows at a time when Barclays’ profits were falling and other directors saw pay cuts.

If, as expected, expensing leads to closer scrutiny of option schemes, companies will be under more pressure to show they align executive and shareholder interests. That may well be the case in some schemes, but there is certainly concern that in others it leads executives to focus on short-term targets at the expense of the long-term health of the business.

When the International Corporate Governance Network set up a committee under Alastair Ross Goobey to consider executive remuneration, it concluded that “share options will probably continue to be an important constituent of long-term incentive schemes, how ever imperfect they are …” But it added, “However, we believe awards should be regular, with performance hurdles that are not subject to much discretion from remuneration committees after their issue, and that they should not be the only long-term incentive.”

Options could become a less-significant element in the total incentive mix in the next few years. The key to shareholder acceptance will be running open schemes, tied to clear performance targets that follow best-practice guidelines. Anything less will simply not be an option.

Directors and all employee share ownership 2003 survey of the FTSE-350 is available from Pinsents at £500. (0121) 260 4005

FD OPTIONS

FDs are receiving generous allotments of share options, according to figures compiled by law firm Pinsents. In FTSE-100 companies, options and long-term incentive plans average nearly 300% of base salary. In FTSE-250 companies, they are less generous, at just under 200%. Overall, that puts FD options and L-tips at more than 200% in FTSE-350 companies.